The economic data flow in the United States remains mixed, with positive and negative signs largely offsetting each other. This leads to a sideways trend (or “steady” trend to put it in more optimistic terms); and based off the comments of most Fed leaders, it has been enough to justify another rate hike in December, assuming the trend continues. The initial estimate of Q3 GDP showed growth rising 2.9% Q/Q, which was slight above expectations and 150 basis points (bps) above the Q2 rate. However, when you look at the underlying details of the report, the fundamentals are largely in line with the post-crisis trend. Personal consumption was expectedly weaker, given the hot run rate from the second quarter; but the inventory adjustment that weighed on growth in the first two quarters reversed course and positively contributed to the headline growth rate, also as expected.
From a broader perspective, this is still an economy trending at 2% growth over a longer time horizon, which is still better than much of the developed economies. But, it still isn’t likely enough to drive significant inflation pressures, which is why the Fed doesn’t appear overly concerned with an aggressive removal of monetary accommodation beyond another rate hike (or even two).
Speaking of inflation, the September consumer price index (CPI) report showed growth in core prices (ex-food & energy) cooling to just 0.1% M/M (2.2% Y/Y). Part of the slowdown in core CPI was attributable to a correction in overheated medical costs in August. Also, owners’ equivalent rent (OER), which measures shelter costs and makes up 31% of the core CPI calculation, continues to run hot, rising at an expansion phase high of 0.36% in September.
The personal consumption expenditures (PCE) index, which is the official inflation gauge in the Fed’s quarterly forecasts, places a lower weighting on OER, and this is one reason why core PCE growth has been lagging behind core CPI on a year-over-year basis. Despite the strong job growth of the last 5 years, there still don’t appear to be strong core inflation pressures in the pipeline; but headline rates have been trending higher with the increase in energy prices. Oil prices have essentially doubled since February, and headline inflation (both CPI and PCE) should rise above 2.5% Y/Y by the end of Q1 2017.
Central Banks Losing Confidence in Policy Effectiveness?
For the last few months, an emerging theme in the markets has been the steepening of global government yield curves, which has been a reversal of the flattening trend in the first half of 2016. Exhibit 2 shows the changes in curve slope since the beginning of the year. A narrative associated with this recent steepening has been whether or not monetary policy is losing its effectiveness. This notion was mostly fueled in the weeks following the Brexit vote, when central bank responses from the Bank of Japan (BOJ) and European Central Bank (ECB) were underwhelming relative to market expectations. More specifically, both the BOJ and ECB seem reluctant at this point to push rates further into negative territory or expand existing quantitative easing (QE) programs. At its October meeting, the ECB chose not to provide any color or hints regarding extending the current QE program that is set to expire in March 2017, which also contributed to this sentiment.
Given the fact that the current global economic outlook remains tepid, there is likely a limit to how much more steepening we could see; but from a market perspective, the central bank technical has overwhelmed the fundamentals for a while now. While central bankers may be wary of adding further accommodation, that certainly isn’t the same as removing accommodation. Therefore, there is likely limited momentum in this trade.
As for the Fed, the futures market is currently pricing a near 70% probability that the FOMC will increase the fed funds target range by another 25 bps, which is up from a near 50% probability at this time last month. The increase in market expectations for a December hike has been driven less by improving data and more by comments from Fed leaders suggesting greater likelihood of action on their part. In fact, one of the most dovish of the regional Fed bank presidents, Chicago’s Charles Evans, suggested in early October that a December tightening “could be fine” and that one rate hike wouldn’t likely suppress inflation growth. We interpret that statement as a compromise with a group of FOMC members that really want to see a 2016 hike, and the impact of one rate hike shouldn’t be enough to alter the current economic trajectory. Evans also said he doesn’t expect inflation to reach the 2% target until 2020 and that he actually sees a benefit in allowing inflation to overshoot the target (consistent with comments from other dovish leaders in recent years).
The near-term wildcard for the financial markets remains the U.S. elections in the coming days. News reports late last week that the FBI was looking into an inactive investigation of Hillary Clinton’s emails had a negative impact on U.S. equity markets, sparking a modest rally in Treasury prices. A Donald Trump victory presents more uncertainty as it relates to future policies from the market’s perspective; but as we’ve learned well over the last several years, a gridlocked Congress has a big impact on what changes the Executive Branch can push through.
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